Building Options at Project Front-End Strategizing: The Power of Capital Design for Evolvability

Project Management Institute

BUILDING OPTIONS AT PROJECT FRONT-END STRATEGIZING: THE POWER OF CAPITAL DESIGN FOR EVOLVABILITY

Guilherme Biesek, PhD Student,

Manchester Business School,

The University of Manchester

Nuno Gil, PhD,

Professor of New Infrastructure Development,

Manchester Business School,

The University of Manchester

(corresponding author)

ISBN: 978-1-62825-042-8

©2014 Project Management Institute, Inc. All rights reserved.

Cover design by David Riedy

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Table of Contents

Manuscript Summary

Acknowledgements

Chapter 1—Introduction

1.1 Problem Articulation

1.2 Conceptual Context and Research Gap

1.3 Research Purpose, Objectives, and Research Questions

1.4 Manuscript Structure

Chapter 2—Literature Review

2.1 Capital Management of Projects: Integrating Risk Management and Design Flexibility at Front-End Strategizing

2.2 Real Options: Theory and Practice

2.3 Final Considerations

Chapter 3—Research Method

3.1 Research Design

3.2 Research Validity and Reliability

Chapter 4—Exploratory Study: Uncovering Design for Evolvability Practices in Single-Funder Capital Project Environments

4.1 Introduction

4.2 Research Context

4.3 Front-end Strategizing

4.4 Using Options Logic in Capital Design for Evolvability

4.5 Assessing the Flexibility Built-in

4.6 Final Observations

Chapter 5—Design for Evolvability in Multi-Funder Environments: Insights From an Embedded Case Study at Network Rail

5.2 The NR Capital Project Context

5.3 Design for Evolvability in NR Capital Projects

5.4 Final considerations

Chapter 6—A Proof-of-Principle of a Method to Design for Evolvability

6.1 Introduction

6.2 Part 1—Analyzing Options

6.3 Part 2—Designing Alternatives

6.4 Part 3—Project Strategizing

6.5 Design for Evolvability Champion

Chapter 7—A Two-Group Controlled Experiment: Lab-based Simulation of the Salford Crescent Redevelopment Project

7.1 The Value of Theory-oriented Experimental Research

7.2 The Purpose of a Lab-based Simulation of Front-end Strategizing

7.3 Details of the Capital Project Informing the Simulation Experiment

7.4 Generation of Experimental Data

7.5 Analysis of the Simulation Results

Chapter 8—Final Considerations: Research Implications and Outlook

8.1 Summary

8.2 Contributions to Theory and Practice

8.3 Limitations and Future Research Directions

8.4 Final Considerations

References

Appendices

A    Interview protocol

B    Questionnaire to Assess Overall Satisfaction with the Front-end Strategizing Process

C    Instructor's Guide

D    Estimating Volatility from Historical Data

E    Generic and Bespoke Design Briefs

F    Route Map for Cross-Pennine, Yorkshire & Humber and North West

G    TOC franchises around the Salford Crescent Area

H    Meeting Agenda

I      Harvard-style Case Study

Manuscript Summary

Capital projects are undertakings that invariably require massive investments, take many years to design and deliver, and produce outputs that are expected to operate for several decades. During project delivery and operational lifetime, the functional and operational requirements are likely to change. To make the project outputs economically adaptable to foreseeable change in the future, sizeable investments in design flexibility may be required upfront at front-end strategizing. Under uncertainty about the future and tight budgets, multi-stakeholder project teams must trade off additional investments in design flexibility at the risk that these investments may not pay off if uncertainties resolve unfavorably in the future. More affordable investments in rigid designs carry the risk of costly adaptation if uncertainties resolve favorably in the future. How to help multi-stakeholder capital project teams bridge their divergences and coalesce their views of the world into a design for evolvability strategy (i.e., a strategy that specifies the qualities of the design that ensure it can cope economically with change in requirements) at project front-end strategizing is the core motivation for this work.

After reviewing the limitations of current practice and theory in the management of capital projects, this study turns to real options reasoning and design literature. By definition, investments in design flexibility can be equated with buying options: If the future resolves favorably, the options can be exercised to adapt the design economically; otherwise, a limited investment has been lost. To advance theory and practice on capital design for evolvability, this study combines empirical research with experimental work. The empirical studies produce two insights: First, they reveal that project teams invariably use options thinking (i.e. the ability to think in terms of leaving options open in the face of uncertainty) intuitively and that real options’ mathematical models are inadequate to support mundane design decisions at front-end strategizing. And second, the empirical studies show that the difficulties of designing for evolvability become amplified whenever multiple stakeholders are involved at front-end strategizing. Characterized by sharp asymmetries in capabilities, knowledge, and power, multi-stakeholder teams must resort to negotiations intertwining informal options thinking with money talks to resolve concept design. Tensions are likely to flare up whenever stakeholders demanding capital investments in design flexibility are not in a position to fund them. These findings suggest nonetheless a formal procedure to design for evolvability may offer a superior approach at front-end strategizing to help teams strike the right balance between short-term affordability and long-term adaptability, as well as to become more accountable for the decisions made at the front end.

To test this proposition induced from the empirical studies, this research develops an original proof-of-principle of a formal framework to support early design decision-making when front-end strategizing capital projects—we call it design for evolvability (DfE). This framework cross-fertilizes literature on project risk management and real options theory with empirical insights from the fieldwork. We also develop a two-group controlled experiment—grounded on fine-grained empirical data from a real-world railway station redevelopment project—to compare the performance of the experimental and control groups in terms of effectiveness, efficiency, and satisfaction. We assembled several teams of postgraduate students to conduct the experiment. About half of the teams were instructed to adopt the formal design for evolvability framework, and received aid of a champion who facilitated the process.

Comparative content and statistical analyses of the experiment deliverables, students’ reflection essays, responses to a questionnaire, and debriefing sessions indicate consistently that a reframed front-end strategizing process improves both the quality of the multilateral conversations substantiating mundane design decisions and the decisions themselves. Specifically, the teams that worked with a design for evolvability champion were systematically more efficient because they tended to find common ground faster than those in the control group. The experimental results suggest that a formal design for evolvability framework makes the team members more aware of the need to share information about their own view of the world in regard to future operating scenarios and funding issues. And as teams build common ground quicker, they become more efficient and have more time left to discuss which options should be designed in and how exactly to fund them. This, in turn, leads to front-end strategizing outcomes that are more effective in reconciling short-term affordability with long-term adaptability. In contrast, unaided teams are more likely to run out of time and to fail to hammer out a deal to fund design optionality, even if they may agree on the need to design in the options. Importantly, our results do not show any statistically significant difference between the two groups regarding their overall sense of satisfaction with the front-end strategizing process. This suggests the teams did not push back on overlaying a formal framework to early design decision-making, possibly because of the time pressure to resolve the front-end strategizing process.

Overall, this research recommends practitioners adopt an options reasoning formal framework to support design decision-making at front-end strategizing. Our results suggest the superiority of this approach, as it increases the quality of the outcomes and the project teams’ accountability for design flexibility decisions. The results do not advocate that teams should outright endorse investments in flexibility. These investments need to be agreed in a multi-stakeholder context and balanced against affordability constraints. But the results show the importance of putting in place a formal decision-making process to ensure a proper debate precedes decisions to endorse or rule out design flexibility investments. An informal process increases the chances that the design flexibility debate—whether inadvertent or not—drops off the agenda at front-end strategizing. And this can create unjustifiable risks that a rigid design moves forward under conditions of high uncertainty. And if costly changes then become required, the project costs must spiral and the project can get derailed. At the limit, failure to properly discuss design flexibility creates an unnecessary risk that a capital project delivers a rigid asset slated to become prematurely obsolete in its operational life. Design for evolvability is therefore essential to pre-empt a lack of intergenerational equity.

Guilherme Biesek and Nuno Gil, Manchester, December 2012

Acknowledgements

This manuscript consolidates research carried on between September 2009 and December 2012 as part of the doctoral studies of Guilherme Biesek at the Manchester Business School (MBS) under the supervision of Professor Nuno Gil. This research was sponsored by a 2 1\2-year external research grant awarded by the Project Management Institute in 2009 (recipient Nuno Gil) and a 3-year MBS PhD bursary (recipient Guilherme Biesek). Its industrial sponsor was Network Rail, the private company but limited by a public guarantee that owns and operates Britain's railway infrastructure.

List of Tables

Table 3.1:   Summary of measures of usability and respective instruments of data collection

Table 4.1:   Numerical assumptions for a discrete estimation of the option value based on single-point estimates

Table 4.2:   Present value of the costs of the two design alternatives (with and without option built-in) and option payoff (in millions of pounds)

Table 5.1:   NR Development Process for Capital Projects (GRIP)

Table 5.2:   Key dates for each GRIP stage for the Reading project

Table 5.3:   Costs for building the Salford Crescent station building

Table 5.4:   Description of the Project Front-end Strategizing in the Sample

Table 5.5:   Summary of evidence on the intertwinement between informal options logic and money talks at front-end strategizing

Table 6.1:   Stage 1 Deliverable: Qualified Options

Table 6.2:   Stage 2 Deliverable: Qualified Alternatives

Table 7.1:   Project stakeholders objectives and information hand outs

Table 7.2:   Summary of the alternative concepts for Salford Crescent Redevelopment project

Table 7.3:   Qualitative comparison of the usability of the front-end strategizing process between the two groups

Table 7.4:   Excerpt of comparative analysis of front-end strategizing process efficiency

Table 7.5:   Summary of the characteristics of the front-end strategizing outcomes for the experimental groups: evaluation and selected quotations

Table 7.6:   Summary of the characteristics of the front-end strategizing outcomes for the control groups: evaluation and selected quotations

Table 7.7:   Comparison of Different Alternatives Produced by One Experimental Group (G7)

Table 7.8:   Comparative analysis of performance effectiveness: selected quotations

Table 7.9:   Descriptive statistics of Assessment of Satisfaction and T-test two-sample assuming unequal variance (7-point Likert scale; 15strongly agree, 75strongly disagree)

Table 7.10: Comparison between the overall satisfaction of the two groups: evaluation and selected quotations

List of Figures

Figure 2.1: Schematic representations of the rationale behind call and put options (adapted from Hull, 2009)

Figure 2.2: Framework of the factors that determine the value of a particular option (adapted from McGrath & MacMillan, 2000).

Figure 3.1: Research method

Figure 3.2: Triangulation of sources of evidence and validation of preliminary findings

Figure 3.3: Photo of a two-group controlled experiment session

Figure 4.1: The old viaduct during an imposed one-way reversible traffic

Figure 4.2: Pile head with space for sitting lifting jacks

Figure 4.3: Cash flow analysis for the two design alternatives

Figure 4.4: Option value for different dates of highway elevation

Figure 4.5: Event tree representation for costs that follow a normal random walk

Figure 4.6: Event tree representation for costs of highway closures modelled as following a normal random walk

Figure 4.7: Payoff (£M) at each node

Figure 4.8: Options values working back through the lattice

Figure 5.1: Layout drawings of the Arpley Chord Infrastructure project (Source: NR's Project Remit for Arpley Chord)

Figure 5.2: Existing station layout (Source: NR's Project Remit for Reading)

Figure 5.3: Overcrowding at the station during a rainy day (Source: Manchester News)

Figure 5.4: Narrow platform and ramp linking the platform to the right-of-way bridge

Figure 6.1: Schematic representation of the method to design for evolvability

Figure 7.1: Excerpt of the transcript of the discussion held by an experimental group

Figure 7.2: Excerpt of the transcript of the experimental group with an ‘incompetent’ champion

Figure 7.3: Excerpt of the transcript of the experimental group with the incompetent champion

Figure 7.4: Excerpt of the transcript of the experimental group with the incompetent champion

Figure 7.5: Excerpt of the transcript of the discussion held by a control group

Figure 7.6: Descriptive statistics of the responses to the questionnaire on satisfaction

CHAPTER 1

Introduction

1.1 Problem Articulation

The design and development of new large-scale infrastructure assets is a fundamental project-based undertaking through which private and public organizations can create value. Physical infrastructure such as airports, railway lines, bridges, factories, hospitals, or power stations are main components (or systems) of critical and large socio-technical systems (or systems of systems) in transport, manufacturing, healthcare, and energy (Hughes, 1987). New infrastructure development (capital) projects play an important role in ensuring that existing socio-technical systems can respond to increasing demand for new services, evolution in usage patterns, and changes in technology. Capital development is also fundamental to ensure the broader socio-technical systems can cope with population increase, deterioration and obsolescence of existing infrastructure, migration flows towards cities, and the globalization of supply chains (Gil, 2009a). They are also advocated by Keynesian economists as one road to recovery in times of an economic downturn. And according to this school of thought, capital investment in large-scale infrastructure projects contributes to the development of national economies by providing temporary and permanent employment, stimulating further investments, and promoting growth and development for local businesses. By the same token, the failure in delivering large-scale infrastructure projects effectively and efficiently can have enormous detrimental impact, both in the medium and in the long term, on the economy of whole nations, given the physical and economic scale of these projects (Flyvbjerg, Bruzelius, & Rothengatter, 2003).

A major challenge in capital development projects is the need to design and build new assets that can adapt economically to evolving requirements over long periods. Infrastructure assets may take many years to negotiate planning consent, design, and delivery. They are also invariably designed to operate for several decades—the construction of some railway stations in the UK, for instance, dates back to the middle of the 19th century. However, during a prolonged project delivery and service lifetime, the external environment will almost certainly evolve: new technology may emerge, user requirements and operating conditions may change, and new regulations may be introduced. These externalities can trigger developments in functional and operational requirements, which need to be accommodated through design changes. The cost of adaptation will then be a function of the flexibility built in the design of the asset.

Design definitions that are flexible to economically accommodate foreseeable changes in requirements in the future may need additional capital investment upfront to create modular architectures (Baldwin & Clark, 2000) or to safeguard integral architectures (Gil, 2007). From a life cycle perspective, this additional capital investment to make the asset definition more flexible may pay off if the foreseeable uncertainties resolve favorably in the future. However, in situations where capital resources are scarce, requests for additional investment at the design definition phase cannot be taken as a given. By definition, large-scale infrastructure projects require large capital sums. Their design definition also takes many years to be negotiated amongst a large number of stakeholders. Any business case for an additional investment in a flexible design solution (which will only pay off if uncertainties resolve favorably in the future) will have to compete with other business cases for more immediate needs. Making a compelling case to invest in design flexibility at the project front-end can, therefore, be a challenge for public agencies operating under tight budgets and struggling to fund projects all deemed urgent. Scarcity of capital resources can also be a problem faced by private developers of infrastructure as they invariably operate under commercial pressures to achieve profits in relatively short timescales.

Failure to make upfront investments in flexibility can nonetheless compromise the ability of the assets to cope economically with foreseeable change. Early-design decision-making in new capital projects therefore requires balancing decisions to make long-term investments in design flexibility (in order to mitigate the downside risk of costly changes in the future) with investments in rigid designs (at the downside risk that adaptation costs will be high if uncertainties resolve favorably). Put differently, capital investments in flexibility at the front end ensure the project can deliver an effective outcome in that it has the capability to respond with reasonable economic costs to potential changes in the environment over its lifetime.

The problem of balancing upfront investments in design flexibility with decisions not to invest at risk but that expediently reduce costs in the short-term is compounded by the need to collectively negotiate these decisions. The number of project stakeholders involved in negotiations to firm up the design can be vast and includes project sponsors (the ultimate client such as a government or a corporation), the project client (typically an agent appointed by the sponsor and often termed the client from a project suppliers’ perspective); future operators, and suppliers; and other relevant stakeholders such as local communities, local authorities, and other public agencies. The claims of these stakeholders over the design definition may exhibit different levels of legitimacy (Gil & Tether, 2011), as well as conflicting priorities, and perceptions of risk (Gil, Miozzo, & Massini, 2012). Despite the autonomy of each stakeholder organization, all organizations may share the ultimate project goal, a phenomenon observed not only in project-based undertakings but also in contemporaneous business ecosystems (Baldwin, 2012). Some stakeholders, however, may advocate design solutions that maximize their individual short-term gains, as opposed to be driven to maximise the shared value that the project can create to the whole. Empirical studies, for example, suggest that often project sponsors might endorse potential underperforming projects as long as they do not carry the risks themselves and are not accountable for performance failures (Flyvbjerg et al., 2003).

In summary, early-design decision-making in large-scale infrastructure projects is invariably the outcome of multilateral negotiations that require factoring in a number of stakeholder perspectives on the costs and risks of design flexibility. Each stakeholder's perspective will be shaped by: 1. different perceptions that foreseeable uncertainties will resolve favorably in the future; 2. the perceived costs of the design adaptation if uncertainties indeed resolve favorably; 3. the appetite to take calculated up- and downside risks; 4. affordability constraints and the stakeholders’ wherewithal to fund investments in flexibility; and 5. A stakeholders’ sense of entitlement to ask another organization to incur the design flexibility costs.

Some stakeholders, particularly cash-strapped ones, may be reluctant to commit capital towards investments in flexibility that may take decades to pay off or that in some circumstances might not even pay off at all (Gil & Tether, 2011; Gil, 2007). Unless another party agrees to fund the costs of built-in flexibility at risk, these stakeholders may be willing to incur the downside risk of costly changes in the future at the expenses of creating an issue of intergenerational equity. A lack of incentives to invest in design flexibility can also arise whenever the organizations commissioned by the project sponsor to deliver and eventually build a project outcome have limited responsibility in regards to its future operational costs and the extent the asset will cope with changes in the environment. For instance, some organizations may avoid including in their bids the costs of design flexibility to remain competitive (Laryea & Hughes, 2011; Garvin & Ford, 2012). The question of who pays, when, why, and how much is therefore central to capital project front-end strategizing. These projects invariably require different parties to coalesce their visions for uncertainty, urgency, and resource constraints into a concept that they can afford collectively and simultaneously ensures the operational longevity of the asset.

1.2 Conceptual Context and Research Gap

Extant research in the management of capital projects and design has inadequately addressed the tensions arising from the need to trade off capital investments in design flexibility with other investments more likely to pay off in the short term. The decision to invest in flexibility to mitigate the risk of costly changes invariably unfolds when capital resources are scarce at front-end strategizing—the period upfront in the project development lifecycle when key stakeholders need to assess alternative design concepts and negotiate a concept to progress into the next project stage (Miller & Lessard, 2007; Morris, 1994). Project teams have been exhorted to implement risk management practices to shield project delivery from the eventual occurrence of foreseeable change in requirements and standards, technological developments, and stakeholders’ opposition to the project (PMI, 2004). These recommendations emphasize the value of change controls and governance structures to ensure the business-case underpinning each change request is assessed before a change can be instructed to project teams. This way, changes that add value can be endorsed to ensure the effectiveness of the project outcome. Changes that fail to deliver value can be rejected. These recommendations, however, fail to acknowledge that the design definition itself will affect the potential impact of late changes to project delivery. Rather, the recommendations tend to fall under instructionist approaches that emphasize the pre-specification of stages to identify, estimate and respond to risk (Pich, Loch, & Meyer, 2002). Kahkonen (2006) argues that there is a fundamental need to improve risk management practices, especially regarding risk concepts and risk perceptions, as well as in terms of providing a more holistic approach that attends to the needs of the different stakeholders. As Lenfle and Loch (2010) put it for the case of product development projects, practices that overemphasize the application of risk management to protect efficiency are bound to overlook opportunities to create value through investments in flexibility and novelty that will make the project outcome more effective. The difficulties in reconciling calls for investing in flexible solutions—which risk that the investments will not pay off—with pressure to reduce capital costs under conditions of uncertainty have motivated calls for building options logic into project front-end strategizing (Gil, 2007; Miller & Lessard, 2007).

Options logic posits that strategy can be used to gain advantage under conditions of uncertainty (Black & Scholes, 1973; Merton, 1973). The aim of option-pricing theory is to provide analytical methods to guide the investor into making strategic investments under uncertainty that will enable investors benefiting from upside scenarios while limiting losses on the downside—that is, options logic introduces an asymmetry in the probability of distributions of payoffs (Merton, 1998). Real options theory draws from analytical studies on financial options, and explores their applicability, not to pure financial investment decisions but to decisions to invest in physical assets (Amram & Kulatilaka, 1999; Smit & Trigeorgis, 2004; Trigeorgis, 1996). Studies in real options have predominantly applied analytical methods to price capital project investments with built-in options (e.g., Lee, 2007; Smit & Trigeorgis, 2004; Zhao, Sundararajan, & Tseng, 2004).

Despite the advances of real options science since the mid–1980s, when options pricing models began to be used to value investments in real assets, and despite the current availability of various analytical methods to help assess capital investments, the uptake of the real options approach in capital investment practice has been slow. In 2002, for example, Ryan and Ryan (2002) indicated that 88.6% of Fortune 1,000 companies had rarely or never used real options. Five years later, the figures in regards to adoption had hardly changed, when Block (2007) reported that only 14.3% of Fortune 1,000 companies were using real options. The slow rate of adoption of real options theory in practice is in marked contrast with Copeland and Antikarov (2001)'s predictions, which suggested that the real options valuations would take off and dominate strategic investment decisions within a few years. Admittedly, there are examples of successful adoption of real options. However, they tend to be observed in industries where large investments with uncertain returns need to be made (Triantis & Borison, 2000). Anecdotal evidence also suggests that real options methods have been mainly applied to sophisticated analysis of capital investment decisions to acquire technology, energy systems, and